Also known as reverse ratio spreads, backspreads are a type of option trading strategy that is best utilized when you feel that a specific underlying stock is going to experience a high degree of volatility and you have a fairly good idea of what direction the price is going to move in but aren’t 100 percent convinced. If the underlying stock then moves a large amount in the direction, you predicted you would earn a large profit. If it moves in the opposite direction instead, then you will still earn a profit, though it won’t be as large. However, if the underlying stock only moves a small amount, then you will see a loss instead.
Put backspread
If you are bearish on the underlying stock in question, then you are going to want to use what is known as a put backspread, or possibly a put ratio spread as put options are utilized in the strategy. To begin using this strategy, you are going to want to start by purchasing any number of put options that are currently out of the money. At the same time, you are going to want to sell a smaller number of put options that are on the money. The end result here is that you end up with a premium net credit.
While you can use any number of put options for this strategy, the simplest variation is to sell 1 in the money put option and purchase two put options that are currently out of the money. If the underlying stock then moves higher than the strike price of the in the money put option that was sold you can allow it to expire while still holding onto the credit premium as all three put options will now expire worthlessly.
If the stock price finishes up somewhere between the in the money strike price and the strike price of the pair of out of the money options, then you will lose money as you will need to buy back the in the money option and the pair of out of the money options are going to expire. However, if the price of the underlying stock drops lower than the strike price of the out of the money put option you will begin to see potentially unlimited profits as the cost of purchasing the in the money option will be greatly offset by the profits you will make selling the pair of out of the money options.
It is very important to keep in mind the fact that you cannot allow your backspread positions to expire as you will have already sold options that will need to be repurchased in order to prevent them from being exercised. As such, it is important to always ensure you have enough available funds to buy back those options in case the price of the underlying stock doesn’t move.
Call backspread
Also known as the call ratio backspread, the call backspread is the type of backspread you are going to want to use if you are bullish on the underlying stock you have your eye on. The call backspread can be done by purchasing any number of out of the money call options and selling a smaller number of call options that are currently on the money. The most common way this is done is by purchasing a pair of out of the money call options and selling one call option that is currently in the money. This strategy will generate a premium as the cost of the two options will be offset by selling the third.
If the price of the underlying stock drops below the strike price, then all three of the options will expire worthlessly. You will still net the initial premium, however. If the underlying stock moves to the point that is higher than the in the money strike price but is still below the strike price of the initial calls, then you are going to lose money as the pair of calls will be worthless but you will still need to buy back the call at the in the money strike price. Once the price of the underlying stock moves past the on the money strike price, then your potential for profit really kicks into high gear. The in the money call will continue to increase in value so will need to be bought back, but this price will be mitigated by the extra gains seen from the pair of calls whose gains will keep pace with it.